What Are Menu Costs?
Menu costs are a type of transaction cost incurred by firms when they change their prices. Menu costs are one microeconomic explanation offered by New Keynesian economists for macroeconomic price-stickiness, which may cause an economy to fail to adjust to changing macroeconomic conditions.
- Menu costs are the costs that a business faces when it decides to change its prices.
- Menu costs are one explanation for price-stickiness, a core tenet of New Keynesian economic theory.
- Price-stickiness describes prices that do not adjust in response to macroeconomic changes.
- Prices that do not change with inflation can contribute to a recession.
- Companies can reduce menu costs by developing a wise pricing strategy so that fewer changes are necessary.
Understanding Menu Costs
Menu costs are the costs incurred by a business when it changes the prices it offers to its customers. A classic example is a restaurant that has to physically print new menus when it changes the prices of its dishes.
The main takeaway from menu costs is that some prices are sticky. That is, firms are hesitant to change their prices until there is a sufficient disparity between the firm's current price and the equilibrium market price to justify the expense of incurring the menu cost.
For example, a restaurant should not change its prices until the price change will result in sufficient additional revenue to cover the cost of printing new menus. In practice, however, it may be difficult to determine the equilibrium market price or to account for all menu costs, so it is hard for firms and consumers to behave precisely in this manner.
History of the Menu Costs Concept
The concept of menu costs was originally introduced by economists Eytan Sheshinski and Yoram Weiss in 1977. Sheshinski and Yoram argued that in an inflationary environment, the prices firms charge will not rise continuously but in repeated, discrete jumps that occur when the expected increase in revenue justifies incurring the fixed cost of changing the price.
New Keynesian economists later applied the argument as a general theory of nominal price rigidity. Economists used it as an explanation for price-stickiness and its role in propagating macroeconomic fluctuations. The most direct application was a 1985 paper by Gregory Mankiw, who argued that even small menu costs could produce enough price rigidity to have a major macroeconomic impact.
George Akerlof and Janet Yellen put forward the idea that firms will not want to change their prices due to bounded rationality, unless the benefit is more than a small amount. This bounded rationality leads to inertia in nominal prices and wages, which can cause output to fluctuate at constant nominal prices and wages.
The Influence of Menu Costs on Industry
When menu costs are high in an industry, price adjustments are usually infrequent. They generally only occur when the profit margin begins to erode to a point where avoiding menu costs results in a greater amount of lost revenue.
How expensive it is to change prices depends on the type of firm and the technology in use. For example, it may be necessary to reprint menus, update price lists, contact a distribution and sales network, or manually re-tag merchandise on the shelf. Even when there are few apparent menu costs, changing prices may make customers apprehensive about buying at the new price. This purchasing hesitancy can result in a subtle type of menu cost in terms of lost potential sales.
Menu costs may be small in some industries, but there is often sufficient friction and cost at scale to exert influence on the business decision of whether to reprice or not. In a 1997 study, store-level data from five multi-store supermarket chains was examined to directly measure menu costs. The study found that menu costs per store averaged more than 35% of net profit margins. This means that the profitability of items needed to drop more than 35% to justify updating the final price of the items.
The authors argued that menu costs may cause considerable nominal rigidity in other industries or markets—essentially, a ripple effect through suppliers and distributors—thus, amplifying their effects on the industry as a whole.
Some menu costs are unavoidable because businesses must raise their prices at some point to keep up with inflation. However, a business can minimize menu costs by devising a pricing strategy that considers their unique value and branding compared to market competitors.
Industry Pricing Factors
Menu costs vary widely by region and industry. This can be due to local regulations, which may require a separate price tag on each item, thus increasing menu costs. Alternatively, there may be relatively few fixed contract suppliers, so there are fewer limitations on price adjustment.
There are also variations on the speed of price limitations. For example, digitally managed and sold inventories have marginal menu costs, and updates to pricing can be made globally with a few clicks.
In general, high menu costs mean that prices are generally not updated until they must be. For many goods, the adjustment is usually up. When input costs drop, the marketers of a product tend to pocket the extra margin until competition forces them to reprice. This is usually done through promotional discounting rather than true price adjustment.
Menu Costs FAQs
What Is Menu Cost Theory in Economics?
Menu cost theory reflects the effect of a price change on a commercial enterprise. The classic example used to illustrate the theory is a restaurant that changes its prices must then bear the cost of printing new menus.
Menu costs, then, are the costs to a firm of changing nominal prices in general. Every time a firm raises or cuts the prices it charges, it faces a substantial financial outlay. Another aspect of menu costs is that prices must go up in line with inflation. Thus, menu costs are unavoidable to some extent.
Which Types of Cost Can Be Included As Menu Costs?
Any costs that occur as a result of a firm changing its prices can be included as menu costs. These costs could include printing menus, updating computer systems, re-tagging items, or hiring consultants to help with pricing strategy. Menu costs can also include consumer hesitancy to purchase at the new price.
Are Menu Costs the Costs of Changing Prices?
Yes. Menu costs result from the cost of changing prices. Purveyors must change their prices, typically, to keep up with inflation, or they may reduce their prices to be more competitive in the market. Either way, there will be associated costs for doing so.
Why Do Menu Costs Arise?
Menu costs usually are the result of inflation. For example, if the cost of food, rent, or wages goes up, a restaurant will have to raise its prices to pay for the extra cost and to make the same profit. When raising prices, there are additional costs, such as printing new menus, updating the website, etc. This means the restaurant will incur extra costs simply because of inflation.
How Can I Reduce My Menu Costs?
The key to reducing menu costs is to have a good pricing strategy. Businesses should analyze their market and determine how they differ from their local competitors. This will show where their value lies where customers are concerned and can help them price their products effectively taking into account their competitor's products and prices. These steps should prevent a business from having to change its prices too frequently, or worse, reduce them.
What Is an Example of Pricing That Changes Infrequently?
Sticky prices exist when prices do not react or are slow to react to changes in demand, production costs, etc. Food in grocery stores tends to be sticky, at least for a time. For instance, if the price of tomatoes plummets, Chef Boyardee would more than likely not lower its prices, even though the input costs decreased. Instead, the food company would simply take the greater margin as profit. In this example, consumers notice no difference in price, even though it should have been lowered according to the classic laws of supply and demand.
This works the other way around, too. Olive Garden is unlikely to hike up its pasta prices because the price of one ingredient goes up. Other examples of sticky prices are hair cuts; health care; and entertainment items, such as books and movie tickets.